Theories of International Trade and Investment BUS4503 International Business Bluefield College February 8, 2010

The Importance of Trade Theory Trade theory helps managers and government policymakers focus on three critical questions: What products should be imported and exported? How much should be traded? With whom should they trade? While descriptive theories suggest a laissez-faire treatment of trade, prescriptive theories suggest that governments should influence trade patterns. Trade and investment policies import substitution: a policy of developing domestic industries to manufacture goods and provide services that would otherwise be imported strategic trade policy: the identification and development of targeted domestic industries in order to improve their competitiveness at home and abroad

International Trade Theory What is international trade? Exchange of raw materials and manufactured goods (and services) across national borders Classical trade theories: explain national economy conditions--country advantages--that enable such exchange to happen New trade theories: explain links among natural country advantages, government action, and industry characteristics that enable such exchange to happen

Foundation Concepts Comparative advantage Competitive advantage Superior features of a country that provide it with unique benefits in global competition – derived from either national endowments or deliberate national policies Competitive advantage Distinctive assets or competencies of a firm – derived from cost, size, or innovation strengths that are difficult for competitors to replicate or imitate Perspectives of the nation and the firm Is the concept that helps answer the question of all nations can gain and sustain national economic superiority Is the concept that helps explain how individual firms can gain and sustain distinctive competence vis-à-vis competitors

Examples of Comparative Advantage Examples of national comparative advantage China is a low labor cost production base India’s Bangalore region offers a critical mass of IT workers Ireland’s repositioning enabled a sophisticated service economy Dubai, a previously obscure Emirate, has been transformed into a knowledge-based economy Examples of firm competitive advantage Dell’s prowess in global supply chain management Nokia’s design and technology leadership in telecommunications Samsung’s leadership in flat-panel TV

Production Possibilities with Absolute Advantage

Production Possibilities with Comparative Advantage

Why Nations Trade: Classical Trade Theories Mercantilism (pre-16th century) Takes an us-versus-them view of trade Other country’s gain is our country’s loss Free Trade theories Absolute Advantage (Adam Smith, 1776) Comparative Advantage (David Ricardo, 1817) Specialization of production and free flow of goods benefit all trading partners’ economies Free Trade refined Factor-proportions (Heckscher-Ohlin, 1919) International product life cycle (Ray Vernon, 1966)

Why Nations Trade: Classical Trade Theories Mercantilism: the belief that national prosperity is the result of a positive balance of trade – maximize exports and minimize imports Absolute advantage principle: a country should produce only those products in which it has absolute advantage or can produce using fewer resources than another country Comparative advantage principle: it is beneficial for two countries to trade even if one has absolute advantage in the production of all products; what matters is not the absolute cost of production but the relative efficiency with which it can produce the product By specializing in what they produce best and trade for the rest, countries can use scarce resources more efficiently

Limitations of Early Trade Theories Do not take into account the cost of international transportation Tariffs and import restrictions can distort trade flows Scale economies can bring about additional efficiencies When governments selectively target certain industries for strategic investment, this may cause trade patterns contrary to theoretical explanations Today, countries can access needed low-cost capital on global markets Some services do not lend themselves to cross-border trade

Classical Theories: Factor Proportions Theory Factor proportions (endowments) theory: each country should produce and export products that intensively use relatively abundant factors of production, and import goods that intensively use relatively scarce factors of production Leontief paradox suggested that countries can be successful in the export of products that require a less abundant resource (e.g., the U.S. with its labor-intensive exports) The Leontief paradox implies that international trade is complex and cannot be fully explained by a single theory, e.g., the abundance of a certain production input

International Product Cycle Theory International product cycle theory: each product and its associated manufacturing technologies go through three stages of evolution: introduction, growth, and maturity In the introduction stage, the inventor country enjoys a monopoly both in manufacturing and exports As the product’s manufacturing becomes more standard, other countries will enter the global marketplace When the product reaches maturity, the original innovator country will become a net importer of the product Applicability to the contemporary global economy: Today, the cycle from innovation to maturity is much shorter making it harder for the innovator country to sustain its lead in a particular product

How Nations Enhance Competitive Advantage The contemporary view suggests that governments can proactively implement policies to enhance a nation’s competitive advantage, beyond the natural endowments the country possesses Governments can create national economic advantage by: stimulating innovation, targeting industries for development, providing low-cost capital, and through other incentives Productivity Levels Selected Countries

Michael Porter’s Diamond Model: Sources of National Competitive Advantage Firm strategy, structure, and rivalry – the presence of strong competitors at home serves as a national competitive advantage Factor conditions – labor, natural resources, capital, technology, entrepreneurship, and know how Demand conditions at home – the strengths and sophistication of customer demand Related and supporting industries – availability of clusters of suppliers and complementary firms with distinctive competences

National Industrial Policy Proactive economic development plan implemented by the public sector to nurture or support promising industry sectors with potential for regional or global dominance. Public sector initiatives can include: Tax incentives Monetary and fiscal policies Rigorous educational systems Investment in national infrastructure Strong legal and regulatory systems

National Industrial Policy: Ireland as an Example Beginning in the 1980s, the Irish government implemented a series of pro-business policies to build strong economic sectors. The “Irish Miracle” resulted from: Fiscal, monetary, and tax consolidation Partnership with the industry and unions Emphasis on high-value adding industries such as pharma, biotechnology, and IT Membership in the European Union; subsidies and investment received from the EU Investment in education

New Trade Theory The argument that economies of scale are an important factor in some industries for superior international performance – even without any clear comparative advantage possessed by the nation. Some industries succeed best as their volume of production increases. For example, the commercial aircraft industry has very high fixed costs that necessitate high-volume sales to achieve profitability. As output expands with specialization, an industry’s ability to realize economies of scale increases and unit costs decrease Because of scale economies, world demand supports only a few firms in such industries (e.g., commercial aircraft, automobiles) Countries that had an early entrant to such an industry have an advantage: Fist-mover advantage Barrier to entry

Why And How Firms Internationalize The internationalization process model of the firm suggests a gradual, evolutionary path to internationalization The slow and incremental nature of internationalization by the firm results from the uncertainty and uneasiness that managers have about cross-border transactions A predictable pattern of internationalization may include the following stages: domestic focus, pre-export stage, experimental involvement, active involvement, and committed involvement

Born Global Firms & International Entrepreneurship The slow, gradual internationalization predicted by the process model is no longer practical or realistic in today’s fast-paced, interconnected economy Today many firms, even those that are young or without much experience, take bold steps to internationalize Indicative of this trend is the emergence of Born Global companies – young, entrepreneurial firms that take on internationalization early in their evolution and leapfrog into global markets

How Firms Gain and Sustain Competitive Advantage Since the MNE has traditionally been the major player in international business, many scholars have offered explanations of what makes these firms pursue, and succeed in, internationalization FDI has been the principal strategy used by MNEs in international expansion; therefore, earlier theoretical explanations relate to motives for, and patterns of, foreign direct investment

Inflow of FDI by Country

Outflow of FDI by Country

Monopolistic Advantage Theory Suggests that FDI is preferred by MNEs because it provides the firm with control over resources and capabilities in the foreign market, and a degree of monopoly power relative to foreign competitors Key sources of monopolistic advantage include proprietary knowledge, patents, unique know-how and skills, and sole ownership of other assets

Internalization Theory Explains the process by which firms acquire and retain one or more value-chain activities inside the firm – retaining control over foreign operations and avoiding the disadvantages of dealing with external partners In contrast to arm’s-length foreign market entry strategies (such as exporting and licensing) which imply developing contractual relationships with external business partners, FDI implies control and ownership of resources

Dunning’s Eclectic Paradigm Three conditions determine whether or not a company will internalize via FDI: Ownership-specific advantages – knowledge, skills, capabilities, relationships, or physical assets that form the basis for the firm’s competitive advantage Location-specific advantages – advantages associated with the country in which the MNE is invested, including natural resources, skilled or low cost labor, and inexpensive capital Internalization advantages – control derived from internalizing foreign-based manufacturing, distribution, or other value chain activities

International Collaborative Ventures While FDI-based internationalization is still common, beginning in the 1980s firms have increasingly utilized non-equity, flexible collaborative ventures in international market entry. A collaborative venture is a form of cooperation between two or more firms. Through collaboration, a firm can gain access to foreign partner’s know-how, capital, distribution channels, and marketing assets, and overcome government imposed obstacles. In an international collaborative venture partners share this risk of their joint efforts and pool resources and capabilities to create synergy.

Types of International Collaborative Ventures Equity-based joint ventures result in the formation of a new legal entity. In contrast to the wholly-owned FDI, the firm collaborates with local partner(s) to reduce risk and commitment of capital. Project-based alliances do not require equity commitment from the partners but simply a willingness to cooperate in R&D, manufacturing, design, or any other value-adding activity. Since project-based alliances have a narrowly defined scope of activities and timeline, they provide greater flexibility to the firm than equity-based ventures.